The High Costs of a Terrible Tax Code

The time is right for another round of comprehensive tax reform.

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Extreme close up of young woman's hand holding pen near US tax form

Jason Fichtner is a senior research fellow at the Mercatus Center at George Mason University. Jacob Feldman is a research analyst at the Mercatus Center.

Washington has long used the federal tax code to advance objectives ranging from increasing "fairness" to granting a competitive advantage to favored businesses or industries. But riddling the code with special provisions has a price beyond the revenue lost from the tax breaks themselves.

In a new Mercatus Center study, "The Hidden Costs of Tax Compliance," we document the costs and implications of the grossly complex U.S. tax system.

The Treasury forgoes approximately $450 billion per year in unreported taxes. Worse, Americans face up to nearly $1 trillion annually in hidden tax-compliance costs. And according to the IRS, taxpayers spent more than six billion hours in 2011 complying with the tax code – that's enough to create an annual workforce of 3.4 million people. If that workforce was a city, it would be the third largest city in the United States. If that workforce was a company, it would employ more individuals than Walmart, IBM, and McDonalds, combined.

[See a collection of political cartoons on the economy.]

The complexity of the tax code also creates an uneven playing field for taxpayers.

About one-third of U.S. taxpayers itemize deductions. This increases the costs of filing taxes and distorts the costs of goods and services ranging from homes to medical care. These deductions also benefit those at the higher end of the income spectrum, as less than 15 percent of households with earnings below the U.S. annual median income file an itemized tax return.

Also, specialized tax incentives favor larger, more established firms. Smaller businesses often are unable to take advantage of provisions such as tax deductions for interest payments and debt financing, and often lack the resources and scale to comply with a complicated depreciation schedule for capital investments.

[Read the U.S. News Debate: Do the Rich Pay Their Fair Share in Taxes?]

The tax code further encourages lobbyists to spend billions on protecting tax privileges and seeking new ones. This appears to be money well spent: A 2009 study found that each additional dollar put toward lobbying translated into $6 to $20 of tax benefits.

Finally, even the agency charged with enforcing the tax code seems overwhelmed by the complexity of the current tax laws. According to the National Taxpayer Advocate – part of the Internal Revenue Service – the IRS itself cannot meet the needs of taxpayers who attempt to contact the agency.

Of the 115 million phone calls the IRS received in fiscal year 2012, it was only able to answer (actually pick-up) 68 percent of the calls. The IRS also failed to respond to almost half of all taxpayer letters within the agency's own established time frame. And in 2011, the U.S.  Treasury Inspector General's reported to Congress that most taxpayers who contact the IRS do not receive helpful responses.

[See a collection of editorial Cartoons on the IRS Scandal.]

The last significant tax reform, the revenue-neutral Tax Reform Act of 1986, reduced economic losses 6 percent by closing just a few tax loopholes and reducing tax rates. Regrettably, the success did not last, as lawmakers quickly loaded the code back up with special provisions.

Today, the time is right for another round of comprehensive tax reform. Washington can achieve successful and lasting reform by significantly reducing – or better, eliminating – special tax provisions and lowering rates. The right tax code reforms will prevent billions of dollars and hours in wasted resources each year.

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